The Internal Revenue Service has provided clarification â€“ including detailed examples â€“ of the tax treatment of state and local tax refunds arising from any year in which the new $10,000 limit on the state and local tax (SALT) deduction is in effect.
The Tax Cuts and Jobs Act (TCJA), enacted in December 2017, limited the itemized deduction for state and local taxes to $5,000 for a married person filing a separate return and $10,000 for all other tax filers. The limit applies to tax years 2018 to 2025.
As in the past, state and local tax refunds are not subject to tax if a taxpayer chose the standard deduction for the year in which the tax was paid. But if a taxpayer itemized deductions for that year on Schedule A, Itemized Deductions, part or all of the refund may be subject to tax, to the extent the taxpayer received a tax benefit from the deduction.
The two examples below illustrate these rules:
Steve paid local real property taxes of $4,000 and state income taxes of $5,000 in 2018. Steveâ€™s state and local tax deduction was below the $10,000 limit set by the TCJA. Steve had other allowable itemized deductions of $5,000, and claimed a total of $14,000 in itemized deductions on his 2018 federal income tax return. In 2019, Steve received a $1,500 state income tax refund due to his overpayment of state income taxes in 2018.
Had Steve paid only the required amount of state income tax in 2018, his state and local tax deduction would have been reduced from $9,000 to $7,500 (the $9,000 he paid, less his $1,500 state refund). As a result, Steveâ€™s itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. The bottom line is, Steve received a tax benefit from the overpayment of $1,500 in state income tax in 2018. Thus, he is required to include the entire $1,500 state income tax refund in his gross income in 2019.
Jackie paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. The TCJA limited Jackieâ€™s state and local tax deduction on her 2018 federal income tax return to $10,000, so Jackie could not deduct $250 of the $10,250 state and local taxes she paid. Including other allowable itemized deductions, Jackie claimed a total of $12,500 in itemized deductions on her 2018 federal income tax return. In 2019, Jackie received a $1,000 state income tax refund due to overpayment of her state income taxes in 2018.
Had Jackie paid only the required amount of state income tax in 2018, her state and local tax deduction would have been reduced from $10,000 to $9,250 (the $10,250 she paid, less her $1,000 state refund). As a result, Jackieâ€™s itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000 that she would have taken in 2018. The difference between Jackieâ€™s claimed itemized deductions ($12,500) and the standard deduction she could have taken ($12,000) is $500. So, Jackie received a tax benefit from $500 of the overpayment of state income tax in 2018. This means she is required to include $500 of her state income tax refund in her gross income in 2019.
Taxpayers who are impacted by the SALT limitâ€”those taxpayers who itemize deductions and who paid state and local taxes in excess of the SALT limitâ€”may not be required to include the entire state or local tax refund in income in the following year. A key part of that calculation is determining the amount the taxpayer would have deducted had the taxpayer only paid the actual state and local tax liabilityâ€”that is, no refund and no balance due.
For detailed information, you can review the ruling at Revenue Ruling 2019-11. If youâ€™d like to discuss how this might apply to your own tax situation, please contact James Ortiz, REDW State and Local Tax Senior Manager, (505) 998-3468.